Commentary
Since 2000, Chinese issuers have widely used variable interest entity (VIE) structures to raise funds from American capital markets. The structure is often employed in industries in which foreign ownership would be restricted or outright prohibited by Chinese regulators.
“Investors really are just playing fantasy football with the Chinese companies because they actually don’t own anything,” Kyle Bass, founder and chief investment officer of Hayman Capital Management, said in a Nov. 22 report.
A common VIE structure would utilize a package of contractual agreements to link a Cayman-incorporated listed shell company with a China-based operating company. The terms of the contracts would provide for the distribution of revenue from the China-based entity to the Cayman-listed VIE. When American investors purchase shares on U.S. exchanges, they only buy the Cayman Islands company shares.
Neither the VIE holding company nor its U.S. investors own any equity interest in the Chinese operating company. And the investors who hold shares in the VIE don’t hold shares or have a direct investment in the Chinese operating company. Ironically, the tech sector is one of the areas in which Beijing is most in need of foreign investment, but it’s also one area in which foreign ownership is banned. Consequently, large Chinese tech companies such as Alibaba and JD.com use a VIE structure to list in the United States. Said another way, American investors who believe they own Alibaba shares don’t.
Jack Ma (R), co-founder and former executive chair of Alibaba Group, speaks next to Steve Forbes (L), chairman and editor-in-chief of Forbes media, during the Forbes Global CEO Conference in Singapore on Oct. 15, 2019. Roslan Rahman/AFP via Getty Images
VIEs aren’t recognized by Chinese authorities, meaning that they’re neither legal nor illegal. This legal ambiguity provides Chinese authorities flexibility in enforcement, or lack thereof, while allowing China to tap into U.S. investors’ pockets to further China’s economic development. As such, the VIEs pose a number of risks to foreign investors, including a lack of legal remedy should the VIE structure be rejected by Chinese authorities. Additionally, there may be no legal recourse in the case of a dispute between the investors of the Cayman-listed shell company and the Chinese operating company.
Moves by the United States to tighten audit supervision rules, as well as sanctions and bans on investment in companies related to the People’s Liberation Army, are expected to drive many VIEs off of U.S. exchanges. Expecting a “homecoming” of VIEs, Chinese authorities have recently adjusted national regulation of variable interest entity structures. In mid-2019, the Shanghai Stock Exchange Sci-tech Innovation Board was established to accommodate domestic listings with VIE usage. Although the first domestic VIE was listed in Shanghai in 2020, there has been no official endorsement as to the legality of the VIE structure. The 2020 Foreign Investment Law of China provides no details on stipulations regarding foreign investors or actual control and the nature of contractual control of VIEs. Consequently, the legal ambiguity of VIEs persists.
Besides VIEs, Chinese authorities have tightened their control of overseas listings by expanding the cybersecurity review requirements related to the 2021 Chinese Personal Information Protection Law. Chinese companies that possess the information of more than 1 million users are required to pass the state cybersecurity review. This was the case with Didi’s U.S. listing in mid-2021. In addition to the tighter regulations discouraging Chinese companies from listing in the United States, meeting U.S. regulatory requirements is also expensive and drives up the cost of listing.
On the U.S. side, general scrutiny by the U.S. Securities and Exchange Commission (SEC) of VIE holding companies has increased, resulting in a number of these companies being delisted from U.S. exchanges. This has forced these companies to relocate their listing to exchanges in China or Hong Kong. The SEC has also requested that Chinese VIEs make additional disclosures informing potential investors of possible risks. On July 30, 2021, SEC Chair Gary Gensler published a statement expressing his concern that the average U.S. investor may not realize that “they hold stock in a shell company rather than a China-based operating company.”
The Holding Foreign Companies Accountable Act and the Public Company Accounting Oversight Board audits aren’t explicitly targeting VIEs. Still, because of the large percentage of Chinese companies that use VIE structures to list in the United States, these additional rules will further increase the risk of investing in VIEs and limit the number of VIEs that can list on U.S. exchanges. Under the new audit rules, about 250 Chinese companies were identified for possible delisting.
With authorities on both sides tightening their regulations, the listing of Chinese companies in the United States has declined significantly. Since the cybersecurity review regulations came into effect toward the end of 2021, only two medium-sized Chinese companies have been listed on U.S. exchanges.
There’s expected to be a trend of VIEs leaving the United States and listing on Chinese exchanges. Additionally, fewer VIEs are expected to list on U.S. exchanges in general. Restricting Chinese access to U.S. investor money will prevent the Chinese regime from achieving its goal of surpassing the United States as the dominant world economic and technological power by 2035.
Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
